Global economic risks to the middle market

THE REAL ECONOMY
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September 13, 2018

Developing markets face growing risks that present a clear and present danger to middle market firms embedded in those economies. Differentials in rate policy between the U.S. central bank and its foreign counterparts, an appreciating greenback, along with an atypical late business cycle fiscal boost, present the major driving forces in interest rate divergence between the United States and emerging economies.

At the very least, the procyclical policies pursued by the United States are going to force emerging market countries to undergo a self-induced bout of fiscal austerity or suffer through what is looking more like a classic emerging market financial and banking crisis. Those changes, along with unique political and policy dynamics, have created the conditions for a slowing global economy with risk of wider contagion, should problems in a select number of economies intensify. While the major risk to the global economic outlook continues to be a global trade spat linked to trade policy in the United States, developments in emerging markets over the past several weeks have reached the point where risks to the global and U.S. economic outlook demand consideration.

In our estimation, the developing economies most at risk include Indonesia, India, Iran, South Africa, Russia, Mexico, Argentina, Brazil, Turkey and Venezuela. Policy and political turmoil in the United Kingdom (U.K.) and Italy represents the most significant risk to the global economy among the developed economies over the next 12 months.

The most significant risks to the global economy over the next year, outside the ongoing global trade spat, reside in Italy, the United Kingdom, Turkey and Venezuela. The potential contagion from rising debt, volatile policy and political dynamics in those economies, if it spreads, will work primarily through financial and trade channels.

Italy’s growing tail risk

Growing debt and unstable political dynamics inside the world’s third-largest bond market represent the largest risks to the global economic outlook over the next 12 to 18 months. Italy characterizes what financial experts refer to as “tail risk,” or a risk greater than three standard deviations," associated with the right side of a probability distribution. The fatter the tail, the greater the risk. Concern is growing that the coalition government will leverage the country’s economic woes to break out of what it considers the European Union (EU) fiscal straightjacket—EU member states cannot run a deficit greater than 3 percent of gross domestic product (GDP)—and potentially exit the monetary bloc, drop the euro and re-impose the Italian lira. Debt dynamics inside Italy imply elevated risk to global financial markets.

At best, any attempt by the government to hit the fiscal accelerator would suggest the global economy might revisit the 2009-2012 European Sovereign Debt Crisis. Italy has a total debt market of €2.4 trillion ($2.7 trillion US), an average weighted years to maturity of 6.84 years, and it needs to roll over €308 billion in debt in 2019. At worst, the exit by Italy from the Euro bloc would create significant systemic risk similar to the collapse of the U.S. housing and financial markets from 2005 to 2010.

The rise of the populist governing coalition, which intends to break out of EU fiscal constraints, will, in early September, likely put Italy’s economy on track toward unsustainable levels of debt the country will find difficult to finance. With a current debt-to-GDP ratio of 131.81 percent, should the ruling coalition follow through on plans to boost fiscal spending, that ratio would rise above 180 percent of GDP over the next decade. While Italy’s fiscal issues are long-term in nature, dating back many decades, it would not take much to tip the economy into crisis.

Bloomberg Chief European Economist David Powell has conducted research that indicates the average cost of debt is roughly 3.1 percent. Using the yield on the Italian sevenyear bond as a proxy for the cost of debt, that instrument is currently yielding 2.763 percent, up 145 basis points from the beginning of 2018. Thus, the economy is only 40 basis points from creating conditions whereby global investors would begin demanding greater risk premia on Italian debt. As Powell noted, if the debt trajectory were to move beyond 3.1 percent, it would hit terrain considered unsustainable by the EU and the International Monetary Fund. Moreover, in 2019, Italy will have to rollover €308 billion in debt. Given the emerging fiscal and debt dynamics, the policy plans put forward by the governing coalition carry implications for global financial markets starting in September 2018 and throughout 2019.

MIDDLE MARKET INSIGHT: Developing markets face growing risks that present a clear and present danger to middle market firms embedded in those economies. Differentials in rate policy between the U.S. central bank and its foreign counterparts, an appreciating greenback, along with an atypical late business cycle fiscal boost, present the major driving forces in interest rate divergence between the United States and emerging economies.

Turmoil in Turkey

In many ways, Turkey serves as a bellwether for other emerging market economies that benefited from the zero interest-rate policy of the past decade in the United States, EU and Japan. Over that period, emerging market foreign denominated debt soared to over $11 trillion today from roughly $3 trillion in 2009. As policy and interest rates increase in the developed economies, financial, banking and currency crises will unfold in select developing economies. The most obvious of those is in Turkey.

With policy normalization moving quite briskly in the United States and the EU signaling it will likely begin to lift interest rates in 2019, many emerging markets are coming under pressure as investors begin to move back into their preferred habitat of risk-free government securities in developed economies. We expect the Federal Reserve to hike its overnight lending rate in September and December by 25 basis points at each meeting, putting the Turkish lira under further pressure. That will result in a deterioration of the government’s ability to meet basic social needs and roll over a prodigious quantity of debt in the pipeline over the next few years. The risk of capital flight is elevated and we would not be surprised if the Turkish government imposes capital controls and further limits on banking activity. On a year-ago basis through August, nonresident ownership of Turkish assets has declined by $41 billion to $51 billion from $92 billion, a sign that global investors are growing quite skittish over the lack of macroeconomic discipline and populist economic policies pursued by the government of Turkish President Tayyip Erdogan.

The most recent bout of financial turbulence is linked to a dispute between Ankara and Washington, D.C., over the status of a U.S. citizen held in Turkey, resulting in the imposition of tariffs by the United States. But Turkey’s economic pressures predate its current trade spat with the United States. Longterm populist economic policies implemented by the Erdogan government have resulted in an inflation rate of 15 percent, which this year triggered a 59 percent devaluation of the Turkish lira and increased investors’ concerns about the level of foreign-denominated debt. Turkey runs a current account deficit equal to 6.27 percent of GDP and has net foreign liabilities equal to 53.4 percent of GDP without adequate currency reserves to cover import needs should there be another run on the Turkish lira.

Investors are beginning to price in such action and perhaps a potential default on international debentures by the government. Global nonfinancial corporations own $330 billion in Turkish debt, the major source of capital flight as private actors look to de-risk their portfolios amid a classic emerging market crisis. Five-year credit default swaps—which provide a useful indication of what it costs to insure against default—have soared to new highs typically only experienced by serial defaulters such as Greece or Argentina. Five-year credit default swaps have increased by 325 basis points, and are up 210 percent since the outset of 2018. With respect to Turkish debt, Spain is holding $82.3 billion, France $38.4 billion, Germany $17.1 billion, Italy $16.9 billion, the U.K. $19.2 billion and the United States $18 billion.

A look at the debt distribution of Turkey indicates significant rollover risk over the next five years. Ankara holds a debt portfolio of 1.5 trillion lira, with a weighted average maturity of 7.27 years. Given the precarious macroeconomic condition of the economy and depreciating currency, the government will likely face a difficult time rolling over roughly 800 billion lira in debt over the next five years, which is why investors are turning to credit default swaps to hedge against any potential default by the country.

Since Turkey is an emerging market bellwether, there is elevated concern about global contagion risk, should investors begin to pull capital from developing markets. While that risk appears manageable for now, should the Fed continue on its rate hike campaign well into 2019 or the global trade spat intensify further in the near-term, capital will flow from emerging markets to developed economies. Economies such as Argentina, Brazil, India, Mexico and South Africa are those at risk should the contagion spread beyond Turkey.

The major economies with exposure to any potential contagion via the trade and financial channels reside in the EU. Exposure in the euro area is approximately 9.1 percent of GDP via the trade channel. Australia trails at 8.9 percent with the U.K. at 3.9 percent and the United States at 3.6 percent. All of those economies have middle market firms with exposure to the aforementioned markets.

Should there be a broader global contagion spreading from Turkey, the most difficult challenge will be containing it via the financial channel. Economies with outsized total claims to emerging markets as a percentage of bank assets are primarily the U.K., EU and the United States. The U.K. has 10.3 percent of its total bank assets linked to emerging markets, the EU 6.9 percent and the United States 5.3 percent.

A hard Brexit?

In many respects the risks to the global outlook linked to Brexit have been somewhat masked by the global trade spat and potential emerging market crisis currently brewing. The U.K.’s exit from the EU is a slow motion train wreck destined to crash this fall ahead of a drop-dead deadline of March 29, 2019, at 11 p.m. GMT. To be clear, this is a purely domestically driven policy choice. The British government still has within its power the ability to reach a reasonable compromise with the EU and avoid a hard landing. However, time is running out.

In our estimation, as the timeline shortens, global financial markets will begin to draw their own conclusions on the probability of a “hard Brexit” despite the protestations from Theresa May’s Conservative Party government. Forwardlooking investors or firms with exposure to the British market should anticipate a bout of market turbulence involving currency volatility and an inability to get critical goods used at earlier stages of production and intermediate goods beginning in the final three months of this year and into early 2019. Some 10.3 percent of British banks have assets linked to total claims on emerging markets; that, along with the growing probability of a hard landing, may cause investors to act sooner rather than later, forcing the hand of the May government.

It is becoming increasingly clear that the U.K. may just put up border restrictions around the entry points to the economy and abrogate its responsibilities under its five-decade membership in the EU. Recent announcements that the government and key private sector actors are stockpiling vital medical and food supplies in the case of a hard Brexit has not bolstered confidence among global investors. They have observed a 13.65 percent depreciation in the British pound since June 2016. Despite signals from the Bank of England that it will consider pushing up its policy rate (a genuine policy error in our estimation given a sluggish British economy), it is almost inconceivable that there will not be further deprecation of the pound and modest inflation shock to the economy in the case of a hard Brexit.

Venezuelan exodus

The long-simmering economic disaster wrought by the populist policies of Venezuelan President Hugo Chavez and his successor Nicolas Maduro have boiled over during the past year, causing the economy to collapse. Hyperinflation of 83,000 percent, the crash of the Venezuelan bolivar, and the exodus of roughly 2.3 million people, or some 7 percent of the population, provide the context for significant human tragedy unfolding in real time across the cone of South America. Venezuela has seen its economy contract by 50 percent over the past five years and has defaulted on $4 billion of global debentures.

During the past 30 days, the Maduro regime has imposed a 3,000 percent increase in the minimum wage, engineered a redenomination of the currency that lopped off five zeros, bringing it in line with black market values. Venezuela will soon face the reality of having to “dollarize” the economy, imposing the U.S. dollar as the primary means of exchange to stave off collapse. The current currency regime is based on a new cryptocurrency tied to oil revenues, which are collapsing.

To put the failure of stabilization policies in perspective, a single packet of rice now costs 2.5 million bolivars (the old currency unit), beyond the reach for most Venezuelans. The lack of available food has caused the average Venezuelan citizen to shed 24 pounds on average in 2017.

Despite sitting on the largest accessible deposits of oil in the global economy, Venezuela’s economy remains fragile. The government’s economic actions over the past month are tantamount to rearranging deck chairs on a sinking Titanic. It is only a matter of if, rather than when, the economy stops functioning and descends into chaos. In the near-term, the International Monetary Fund has estimated that inflation will likely surge to 1 million percent by the end of 2018. It is just a matter of time before imports collapse and the government defaults on the remainder of its global debenture obligations.

Under normal conditions, Venezuela would be able to trade oil for aid or put up its resource-rich oil fields as collateral for a sponsored bailout from the International Monetary Fund or the United States. Given both the new currency regime and the lack of investment in vital infrastructure, that is unlikely. Moreover, during the past month, a U.S. judge gave a Canadian mining company permission to seize the assets of Citgo Petroleum’s parent firm, the Venezuelan state owned oil company that provides the majority of government revenues, making any financial rescue nearly impossible.

The impact of Venezuela’s economic collapse on South America is best illustrated by its massive refugee crisis. The nation of Colombia, situated on Venezuela’s southwest border, has absorbed roughly 22 percent, or 500,000, of the 2.3 million individuals that have left the country in search of economic stability. It is most at risk economically due to the massive southern migration.

While Colombia’s economy grew at an impressive 2.5 percent in the first half of 2018, it is just beginning to recover from a sluggish growth rate in 2017 of 1.7 percent that capped four years of subpar growth.

Colombia suffered significantly from the global crash in commodity prices between 2014-2016. The end of Venezuela’s Maduro regime, whenever that is, will result in significant economic collateral damage, much of which will fall on the not-so-sturdy shoulders of the Colombian economy. China is the largest holder of Venezuelan debt, with an outstanding portfolio of $23 billion.

Ecuador, Peru, Bolivia, Chile, Argentina, Uruguay and Brazil are also absorbing high volumes of Venezuelan immigrants in search of food, medicine and shelter. Venezuelan citizens are currently the largest number of asylum seekers in the United States.

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